Are you still playing by the old rules?Prashant Vaishampayan
Jonathan Clements explains that there are many investors, and indeed financial advisers, who are still playing by the old rules. Are you one of them? Do you know those timeless financial principles? Sometimes they don’t age so well. Indeed, if you’re still hewing to the financial wisdom of the 1980s, you’re likely hurting yourself today. Here are three examples:
Goodbye, Star fund Manager: Many investors continued to hunt for the next superstar fund manager. Investors would scour past mutual fund performance, confident that it would be a reliable guide to future results. Today, that confidence has largely evaporated — with good reason: Most fund managers lag behind the market and, among those who don’t, there’s no surefire way to identify the winners ahead of time or distinguish the truly skilful from the merely lucky. Indeed, the proliferation of index funds over the past two decades hasn’t just offered investors an alternative to actively managed funds. It’s also given folks a measuring stick against which to compare those active managers—and, year after year, the managers keep coming up short. What’s amazing isn’t that investors have lost confidence in past performance and their belief in exceptional money managers. Rather, what’s amazing is that it took so long.
Broken Yardsticks: Starting in the 1990s, stock market valuations broke out of their historical range and climbed skyward. Old-timers warned that valuations would soon come crashing back to earth. They’re still waiting. To be sure, rising price-earnings ratios and declining dividend yields can be partly explained by falling interest rates, which have made stocks more attractive relative to the main alternative — bonds. But it seems some enduring financial trends are also driving the rise in stock valuations, including falling investment costs, ever more capital available to invest, a rising appetite for risk, corporations’ growing preference for stock buybacks over dividends, and the move to spend less on plant and equipment and more on research and development. This last change has resulted in lower reported earnings and hence higher price-earnings multiples. The upshot: Today’s stock market valuations are undoubtedly rich by historical standards. But it’s hard to know what to do with that information or whether we should even worry—because it doesn’t tell us anything about short-term returns and it may not be that important to long-run results.
Today’s tiny bond yields: The biggest impact is on retirees. Indeed, the core strategy for many retirees — buying bonds and then paying the household bills with the interest — simply doesn’t work anymore. After all, how many retirees are rich enough to live off a portfolio of high-quality bonds, which today would likely kick off less than 6% in India? It’s time to stop thinking about bonds as a standalone investment. Instead, their sole remaining role is as a complement to stocks. They can provide offsetting gains when the stock market nosedives, a rebalancing partner for stocks, and a way to raise cash if it’s a bad time to sell shares. Clements’ advice for retirees: Forget investing for yield and instead aim to earn a healthy total return by allocating at least half your portfolio to stocks. In buoyant years for the stock market, look to harvest gains. In rough years, get your spending money by selling bonds and cash investments.